One of the biggest mistakes people make in planning for retirement is failing to account for inflation. If you retire at age 65 and live to 95, with an average inflation rate of 3% per year, the cost of living will increase by around 90% during your retirement. That means if you could comfortably live on $3,000 per month when you retire, you'll need $5,700 for the same standard of living 30 years later. However, governments and consumers can gauge and plan for this.
The cost of living adjustment (COLA) calculates the effect of inflation on a person’s buying power and proportionately adjusts wages, salaries or benefits. Inflation is measured using the consumer price index (CPI) as an objective measure of how a typical household maintains its standard of living. COLA is used to calculate Social Security payments and employee relocation costs and is also used to adjust wages over time. It can be essential in your retirement planning.
Understanding the Basics of Cost of Living Adjustment
The cost of living adjustment gives individuals and households a realistic idea of how to adjust salaries and budgets to maintain their standard of living.
What Is a Cost of Living Adjustment (COLA)?
What is the cost of living adjustment? COLA is salary increases, hourly wage increases or increases in Social Security payments to compensate for inflation. COLAs are not merit-based increases but simply an acknowledgment of a gradually changing economy and increased cost of living.
The cost of living, measured by the consumer price index, is the cost of maintaining a certain standard of living, including the price of milk, bread, gas and other basic consumer goods. Economists and individuals use cost of living calculations to compare the cost of maintaining a certain standard by geographic region. Most cost of living adjustments are calculated by state or metropolitan area.
COLA is used most commonly for Social Security and Supplemental Security Income (SSI). In these cases, a COLA adjustment is made to counteract the effects of rising prices of consumer goods — called inflation. Automatic yearly COLAs began for Social Security and SSI recipients in 1975.
Social Security COLAs usually equal the percentage increase in the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) for the previous year.
How Does a Cost of Living Adjustment Work?
In terms of government-based COLAs, Social Security and Supplemental Security Income recipients are eligible for COLAs. Government employees may be eligible for COLA from age 62. Employees of private businesses and corporations may be eligible for COLA based on individual company policies.
How to Calculate COLA
The steps to calculate COLA are simple. You can find the CPI for urban wage earners or the published COLA adjustment from the Social Security Administration (SSA), which usually announces the COLA for the following year in October.
To calculate COLA, the SSA compares the average CPI-W for the current year's third quarter to the average CPI-W for the third quarter of the last year. If the average CPI-W has increased by over one-tenth of 1%, the SSA will approve a COLA and increase benefits.
The COLA for 2023 was 8.7%. For 2024, the COLA is 3.2%. Typical projected COLAs for future years are 2.4%. The COLA expresses the increase of benefits from Social Security or SSI for recipients. For example, if someone received Social Security benefits of $10,000 in 2022, in 2023, their benefit would increase to $10,870.
COLA and Its Implications on Social Security and Retirement
COLA affects both Social Security benefits and retirement planning. When you calculate how much you need to retire, you will need to plan for cost of living adjustments with time. Because of inflation and the resultant increase in prices of consumer goods, the average retirement income has been increasing steadily for decades. For workers who retired in 1987, their Social Security benefit in 2023 will be nearly three times the initial benefit.
Useful Tips on Maximizing COLA Benefits
COLA benefits are calculated automatically, so there's nothing you can do to increase it. But there are many ways to adjust to the rising cost of living or maximize your Social Security check. First, to maximize your Social Security check before retirement you can:
- Work more years
- Work to max out earnings
- Delay collecting benefits
To save more on everyday expenses consider:
- Keeping a budget
- Tracking all expenses
- Supplementing retirement income with a side hustle
- Looking for free or low-cost entertainment and activities
- Use public transport, bikes or other low-cost transportation
- Save to splurge on special activities or experiences
Maximizing Your Quality of Life
COLA is a useful indicator to judge an inflation-adjusted lifestyle and current cost of living indicators. If you're a Social Security recipient, you don't have to do anything to receive the increased COLA benefit. If you have other retirement savings, consider the best investments for retirees that can protect your wealth and help you stay ahead of inflation. With planning and understanding of COLA, you'll be better prepared to save for the future and adjust your budget to account for inflation over time.
Frequently Asked Questions
What does it mean to adjust for the cost of living?
An adjustment in the cost of living is a change in income or benefits that change with inflation and the increasing cost of consumer goods. To counteract inflation, the government, companies and unions make cost-of-living adjustments for retirees, employees and other beneficiaries.
What is a typical cost-of-living adjustment?
A typical cost of living adjustment varies by year. After years of high inflation, you may see a bigger increase. In 2023, the COLA was 8.7%, although the average projected increase for coming years is 2.4%.
What steps should I take to receive a COLA for my Social Security benefits?
There are no steps you have to take to receive a COLA for your Social Security benefits. COLA is calculated and added to Social Security automatically.
What is the difference between a raise and a COLA?
A raise is usually based on performance, job position, promotion or activity related to your job. Your employer may choose to give you a raise based on their criteria and may offer a raise of any amount. In contrast, COLA is based on a set index calculated by the Social Security Administration or Bureau of Labor Statistics and is not dependent on your performance.
About Alison Plaut
Alison Plaut is a personal finance writer with a sustainable MBA, passionate about helping people learn more about financial basics for wealth building and financial freedom. She has more than 17 years of writing experience, focused on real estate and mortgage, business, personal finance, and investing. Her work has been published in The Motley Fool, MoneyLion, and she is a regular contributor for Benzinga.